Europe can cope with a stronger currency

US dollar weakness was the key trend in currency markets last year. We expect this to continue in 2004. We are forecasting the low in the dollar to be at EUR/USD 1.40, USD/JPY 90 and GBP/USD 2.00.
Our forecasts have prompted some questions on the impact on the Eurozone economy and whether the ECB would intervene verbally or financially. Below we argue that the Eurozone can indeed cope the euro's strength and that it would take a much more dramatic slide in the dollar to prompt intervention. There are five key points.

1. The recent rise in the euro needs to be seen in perspective. It is important not to be sucked in by headlines about the 'life-time' highs against the dollar. The single currency was only born in 1999. Looking at the basket of national units that made up the euro, the currency has simply returned to its long-run average and was at a equivalent of EUR/USD 1.40 just ten years ago.

2. It is also misleading to focus exclusively on the value of the euro against the dollar. A rise to 1.30 as part of a general move lower in the USD would have much less impact than a rise to 1.30 driven solely by EUR strength. (Thus, comments that 1.30 or 1.35 is a 'critical level' make little sense.) On a trade-weighted basis, the euro has only just returned to its launch level. Obviously, we have seen a big move down and a big move up since then. But just as the fall in the euro from 1999-2000 failed to cause a Eurozone boom, it is hard to see why the recovery from 2001-2003 should cause an economic crisis - especially when the world economy is booming again. There is a particularly good correlation between US business confidence and German business confidence, lagged around six months. Thus, even though hard data in Germany is currently still weak, the surge in the US implies a strong recovery by the second half of 2004.

3. There is no sign that the rise in the euro is damaging export prospects, even in Germany. Export expectations, as measured in the December IFO survey, are at their highest level since 1997. The Reuters PMI showed that German manufacturing confidence is at its highest since January 2001, led by export orders. There are still some valid concerns that the euro appreciation will erode the profitability of German exporters. They may sell more goods and enjoy higher revenues in dollar terms, but lose on the currency movement. The latest corporate results, due in the coming weeks, should therefore be watched carefully. But the bottom line is that the German economy is likely to grow by around 1.5% this year, compared to around 0.2% last year. It therefore makes little sense to be more worried about corporate Germany in 2004 than in 2003.

4. The rise in the euro brings positives for the Eurozone economy as well as negatives. A stronger currency is good news for importers (including large chunks of German manufacturing) as well as for consumers. It will also make it easier for the ECB to achieve its inflation target of 'close to but less than 2%'. If the currency's strength becomes a serious hindrance to growth the ECB is more likely to cut rates rather than intervene.

5. There has been some progress on structural reform in Germany, France, and Italy. More is required but this will help reduce the loss of competitiveness from the currency. There are also signs that companies are cutting costs and increasing productivity. That is already being reflected in moderate wage demands for 2004 from the key German trade union, IG Metall. Usually it asks for 6%. This time it is asking for 4%, and will probably settle for nearer 2%.

The message therefore is that while the rise in the euro will inevitably dampen growth prospects, the currency is only one of a number of factors influencing the direction of the Eurozone economy. Given a booming global economy, low interest rates and an accommodative fiscal stance from European governments the euro's strength does not look quite as threatening.